Xerium Technologies (XRM) – Recurring Revenues/High Leverage

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Xerium Technologies (XRM) makes consumable products for paper manufacturers. They sell two broad types of products: paper machine clothing (2/3 of revenues) and paper machine roll covers (1/3 of revenues). Paper machine clothing is a specialty woven textile that helps guide the paper fibers through the paper machine while allowing water to drain out. Roll covers are generally rubber or polyurethane and cover the metal paper machine rolls that roll the paper fibers through the machine. Paper machine clothing has to be replaced every few months, while roll covers are replaced every 1-2 years.

Xerium is an industry leader in a consolidated, mature market. With 15% market share they are the number two player in paper machine clothing behind Albany International (AIN). They are the largest producer of roll covers with 33% market share.

XRM sales are tied to the level of global paper production. While the paper market is highly cyclical and also undergoing structural changes, in the big picture paper production should be a steady slow grower in line with global GDP. As a global maker of products that can be fitted to any paper machine, XRM is not tied to a specific geography or segment of the paper market. So they should be able to adapt to the shifting of paper demand growth from Western economies to Asia, as well as to the decline in newsprint and printing paper which should be filled in with growth in packaging and tissue papers.

XRM was hit hard in 2009 as paper production capacity was taken offline and customers drew down their consumables inventories. The slowdown combined with their highly leveraged balance sheet forced XRM into tripping their debt covenants. That led to a prepackaged bankruptcy in March 2010, which enabled XRM to reduce their debt load by $140 million. The business recovered strongly in 2010 and the stock hit $24 in April of 2011. Since then the stock has gone on a sharp downtrend to the current price under $7.

Revenues have rebounded since hitting a trough of $500 million in 09. They came in at $548 million in 10, and are at $586 million for the TTM, though still off 08 revenues of $638 million. There is a note of caution going forward as bookings in Q3 declined to $134.5 million from the $140-145 million range of the previous several quarters. Paper markets cooled off in the second half of the year, and XRM management was cautious on the Q3 call in regard to near term sales.

Gross margin has been more of a problem than the top line since emerging from bankruptcy. The bankruptcy plan projected gross margins in the 41% range, but they have been well under 40%, falling to 36.6% in Q3 11. That has been caused mainly by cost inflation in raw materials. Another factor is the higher percentage of products being sold into the higher-growth Asian markets, which are lower margin. Additionally, XRM does not yet have an extensive manufacturing presence in Asia so they bear higher shipping costs when selling there. XRM is trying to offset the margin decline by increasing sales of their “new products”, which have innovative or advanced technology features that they think can command higher margins. They have been successful in growing new product revenues, but it has not been enough to offset the margin erosion.

This chart is a nice summary of the recent EBITDA numbers (note adjusted EBITDA adds back stock comp and restructuring charges):

Turning to the balance sheet, XRM still has a large debt load even after the bankruptcy. They currently have $475 million of debt and $43 million in cash. XRM was able to refinance in May to push out maturities. They have $231 million of first-lien floating rate debt due in 2017, which they are currently paying 5.6% on. They have $240 million in senior notes at 8.875% due in 2018. The first-lien debt only has $2.4 million of amortization a year and at current levels XRM has about $35 million in annual cash interest. While XRM is levered almost 4X EBITDA, they should not have a problem servicing the debt. However, they do have a total leverage covenant of 4.75X total debt/adjusted EBITDA, which falls to 4.5X in June. If revenues weaken in the next quarter and gross margins stay low it is possible XRM could put up only $25 million in adj. EBITDA for the quarter. If the weakness persists for a few quarters then XRM would start to get close on the covenant.

Here is the current market valuation:

Looking at run rate EBITDA, management has noted the fourth quarter of 2010 saw exceptionally strong margins due to high demand as customers restocked after the XRM bankruptcy as well as some one time items. So it is probably more prudent to annualize the the first three quarters of 11 EBITDA of $82.6 million, which comes to $110.1 million annualized. That is an EV/EBITDA ratio of 4.9X. The close comp AIN trades at 5.7X, but AIN is much less levered. The more interesting story is the free cash flow to the equity. Current cash interest expense is about $35 million. Cash taxes are about $10 million. (XRM has NOLs coming out of the bankruptcy but they are in jurisdictions where they are  not earning money so they have not been able to utilize them.) Management has guided to $30 million in capex in 2011. That leaves $38 million in FCF before working capital changes, or a 37% FCF yield:

A major caveat is that working capital has been a use of cash recently. Sales have been growing, but working capital has been rising faster as this chart shows (from XRM earnings release presentation):

This has hampered XRM’s ability to get cash out of the business and pay down debt. Management has targeted improved working capital management coming out of bankruptcy, but it has yet to manifest itself. TTM cash from operations before working capital changes is $63.1 million, but only $48.1 million with working capital changes. Sales were up $48 million over the prior period, but working capital was up $15 million. However, working capital did improve in Q3 and they were able to pay down $11.7 million of debt.

The potential investment thesis for XRM is pretty simple at the current market cap. If XRM can generate consistent free cash flow then value can accrue to the equity very quickly given the small size of their market cap in relation to their enterprise value and potential cash generation. At the current $6.75 a share price XRM market cap is $102 million. If they pay down $30 million in debt and hold the same enterprise value then the equity value increases 29%. As icing on the cake, the enterprise multiple might expand to something closer to AIN’s as the leverage profile moderates. Even one turn of EBITDA at these levels would more than double the price per share. Management has indicated their intent to delever and started the process in the last quarter. This slide from their October presentation seems to be indicative of their thinking (note the share price was higher at the time):

Of course leverage can cut both ways and XRM is tied to a volatile paper market. If the macro economy goes haywire then the things could get dire quickly once again for XRM. One difference this time around might be that customer inventories are not at the levels they were at before the 08 plunge, so a downturn might not hit sales as badly. And while they still do not have a great deal of breathing room on their debt covenants, in a potential breach they might get more relief from debt holders given their reduced overall debt levels as compared to the pre-bankruptcy period. I am very tempted by XRM, but for now I can’t get past the lack of stability in their markets combined with the high leverage.

Disclosure: No position

P.S.

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16 Responses to Xerium Technologies (XRM) – Recurring Revenues/High Leverage
  1. Daniel Milstein
    January 26, 2012 | 10:21 am

    That is true,Elie. As an author and business man, I can relate to how you said, “Xerium is an industry leader in a consolidated, mature market”. I hope more people discover your blog because you really know what you’re talking about. Can’t wait to read more from you!

    Reply
  2. Daniel Milstein
    January 26, 2012 | 10:25 am

    That is true. As an author and business man, I can relate to how you said, “There is a note of caution going forward as bookings in Q3 declined to $134.5 million from the $140-145 million range of the previous several quarters”. I hope more people discover your blog because you really know what you’re talking about. Can’t wait to read more from you!

    Reply
  3. Manoj Roy
    January 26, 2012 | 9:09 pm

    Elie – Very good analysis. What is your thought on XRM’s ability to grab market share from AIN. All the product innovation stuff that Stephen Light talks about … how much of that stuff is really relevant in increasing mkt share. Do you think ‘leverage’ is the only reason for the descrpency in AIN & XRM valuation. Have you looked at ABH?

    Reply
    • Elie Rosenberg
      January 27, 2012 | 9:16 am

      Thanks Manoj. I have looked at ABH, but can’t say I have done a deep enough dive to determine whether XRM can gain market share with its “new products”. If you read ABH’s filings they have the same product innovation strategy in their PMC segment, so without further research it is hard to know.

      On the valuation discrepancy- ABH has double the PMC market share of XRM so could argue they get some credit for that. Also ABH is exposed to some very different markets than XRM outside of the PMC business (although somewhat less so after selling off the door business recently) so we could argue we are not exactly comparing apples to apples.

      Reply
  4. Peter
    March 14, 2012 | 8:43 am

    10K released this morning, stock in a nosedive. What’s going on here?

    Reply
    • Elie Rosenberg
      March 14, 2012 | 8:52 am

      Weak quarter.

      Reply
      • dd
        April 2, 2012 | 11:05 am

        hi Elie, any thoughts on this one after digesting the quarter, conf call and 10-K? i find this one pretty interesting, although the leverage concerns me — not sure why they didn’t emerge from BK with maybe 3x leverage rather than where they are now.

        Reply
  5. Elie Rosenberg
    April 2, 2012 | 3:11 pm

    I haven’t been following it that closely, but from the recent Q and conference call it didn’t sound like the story has changed much. It is a very cyclical business with a lot of leverage. There are also some structural issues (customers extending roll life, low margins in Asia which is supposed to be their growth area) that don’t help things. I am still not really comfortable with it.

    Reply
  6. xrmguru
    May 8, 2012 | 8:17 pm

    another weak quarter, but cashflow resiliently strong. With only $60mm of equity value and minimal default risk, where does the company go from here?

    Reply
    • Elie Rosenberg
      May 9, 2012 | 8:46 am

      Results were terrible. They can make the interest payments but a few more poor quarters and they could easily trip their debt covenants. If the paper markets turn in the second half of the year like they are predicting then the stock could bounce, but longer term I am not sure their business is sustainable with the debt level they have.

      Reply
    • dd
      May 9, 2012 | 9:00 am

      wow, you flipped on this one pretty quick, eh there Elie?

      Reply
      • Elie Rosenberg
        May 9, 2012 | 9:07 am

        Not sure what you mean by flipped…see my conclusion in the original article- “but for now I can’t get past the lack of stability in their markets combined with the high leverage.”

        Reply
        • dd
          May 9, 2012 | 9:11 am

          37% free cash flow yield to now possibly tripping covenants. quite a move for 2 quarters results in a cyclical business.

          Reply
          • Elie Rosenberg
            May 9, 2012 | 9:20 am

            Things can go south quickly in a very cyclical business with a lot of leverage- that was why I stayed away initially. They could still have a 40% FCF yield and be in violation of their total leverage and interest expense covenants. They are not that close yet, but could be with another few quarters of declining EBITDA.

        • dd
          May 9, 2012 | 9:16 am

          to be fair, Elie, you were openly cautious on this one.

          my biggest issue with this mgmt is they keep spending on “growth” capex, while EBITDA does not grow over the course of a cycle — they should be 100% focused on the minimum maintenance level of capex and maximum debt paydown. seems obvious enough.

          Reply
  7. dd
    May 9, 2012 | 9:24 am

    1) it’s pretty tough to go BK in this credit environment, especially when you’re leveraged 2-3x through the banks. remember last time was an anomaly with the euro paper holder.

    2) i think it’s pretty clear that this quarter is the bottom … for now.

    Reply
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